LEGAL RULING NO. 417

RETROACTIVE CHANGES TO BAD-DEBT
RESERVE FOR SAVINGS AND LOAN ASSOCIATIONS

Facts

Advice
has been requested in two cases where savings and loan associations have attempted
to modify in a later year the bad-debt reserve claimed on a return for an earlier
year:

1. The first case involves an association that seeks
to increase the bad-debt deduction to an amount greater than the addition it made
to the reserve for bad debts on the savings and loan's books for that year;

2.
The second case involves an association that seeks to increase the bad-debt deduction
to an amount equal to or less than the addition it made to the reserve for bad
debts on the savings and loan's books for that year.

In
neither case have there been any assessments of additional tax for the year involved
or a change of the taxpayer's bad debt loss ratio.

Questions

1.
May a savings and loan association retroactively increase the amount of its bad-debt
deduction, after the date prescribed for filing the return has expired, to an
amount greater than the addition it made to the reserve for bad debts on the savings
and loan's books for that year?

2. May a savings and loan
association retroactively increase the amount of its bad-debt deduction, after
the date prescribed for filing the return has expired, to an amount equal to or
less than the addition it made to the reserve for bad debts on the savings and
loan's books for that year?

Decisions

1.
No.

2. Yes.

Discussion

Regulation
24348(b) allows a savings and loan association to deduct each year a reasonable
addition to its reserve for bad debts. The purpose of the reserve is to allow
the taxpayer to exclude from gross income loans which foreseeably will not be
repaid. The taxpayer is initially given the privilege to determine the amount
of the yearly addition. That determination should be made at or near the close
of the income year, based upon facts existing at that time. The best evidence
of the taxpayer's determination generally will be the amount shown on its books,
reflecting actual loss experience. A determination fairly made at the close of
the year may not be enlarged or diminished at a later date, for then the reserve
would cease to be a true reserve and the taxpayer, contrary to the spirit of the
statute, would be permitted to deduct worthless debts in a year other than that
in which their worthlessness would be realized. Therefore, when considering retroactive
increases to additions to bad-debt reserves on returns, the amount of increase
allowed is limited to the amount of addition already entered on the savings and
loan association's books, provided the increase is otherwise allowable by the
Bank and Corporation Tax Law and the regulations promulgated thereunder and within
the period of the statute of limitations.

Question
#2 requires no adjustment to the association's books. As long as there is no retroactive
adjustment to the association's addition for bad-debt reserve on its books the
bad-debt deduction claimed on the return may be amended provided it is within
the period of statute of limitations for such amendments and otherwise allowable
by our laws and regulations. Appeal of Culver Federal Savings and Loan Association,
Cal. St. Bd. of Equal., February 14, 1966, CCH 203-256, P-H 13,383.

This
opinion is not meant to apply for a year in which additional assessments have
been proposed or for any year not barred by the statute of limitations where the
association's loan loss ratio is revised by this department.

Given
a hypothetical of:

1977

1978

Bad-Debt
Deduction Claimed on Books

$76,000

$10,000

Bad-Debt Deduction
Claimed Original State Return

-0-

-0-

Bad-Debt Deduction
Claimed Amended State Return (within the period of statute
of limititions)

76,000

33,000

In applying these legal rules to
this hypothetical situation, the retroactive deduction of the previously determined
addition to the bad-debt reserve made in 1977 for $10,000 and in 1978 for $76,000
may be allowed, as long as this is done within the statute of limitations and
otherwise allowable by the Bank and Corporation Tax Law and the regulations promulgated
thereunder (particularly Reg. 24348(b) ). However, the subsequently desired reasonable
reserve addition of an additional $23,000 for 1977 cannot be allowed as this would
constitute a retroactive increase to the determination on the books, which is
not allowed.